Topic 3: Bank Regulation Flashcards
Basel Committee (BCBS)
- BIS
- BCBS
- Challenges
• Bank for International Settlements (BIS)
– The “Central Bank for Central Banks”, Established in Basel Switzerland in 1930
• Basel Committee on Banking Supervision (BCBS)
– Established at BIS in 1975, but distinct from it / No direct legislative power, issues “guidelines” / Implemented into law by national regulators
• Challenges
– Creating regulation for economies in different states of development
– International banks subject to similar, but not identical, regulatory frameworks
– Significant risk of unintended consequences (complex system)
Regulatory Lessons from the Crisis
Themes: global stability / liquidity / quant models / incentivisation
– Global financial system is highly interconnected (Not just about individual bank)
– Participants in that system will assume the worst if those linkages are uncertain
- Liquidity
- Quantitative models are not a panacea: garbage in/garbage out, black swans
- Disaster plans need to be credible, and tested
- Conduct is driven by perceived incentives (personal cost vs personal benefit)
– Accountability matters
Classes of Bank Regulation (4)
• Prudential
Bank solvency – ability to pay all debts eventually
Restricts leverage (which limits profits)
Economic lever to direct bank behaviour via “capital charges”
• Liquidity
Pay near‐term debts on time as they become due
Lack of liquidity can lead to solvency issues
• Disclosure
Before 2007/09 crisis, disclosure seen as a primary mechanism for conduct regulation
• Conduct
Post 2007/09 crisis, explicit conduct regulation and accountability has been the growth area
Regulators no longer rely so heavily on transparency alone to steer behaviour
Bank Prudential Regulation
- Aim is..
- Basel Accord is defined in terms of..
- Min capital - now, increase to…
- Aim is a risk‐sensitive leverage ratio
- Basel Accord defined in terms of a scaled quantity ‐ “Risk‐Weighted Assets” (RWA)
- Minimum capital defined as a fixed fraction of total RWA, including non credit risk RWAs
- The prescribed fraction is currently 8% (Pillar 1) but will rise to ≥ 10.5% by 1 January 2019
Name the Three Pillars of the Basel regulatory regime
- Pillar 1 – Minimum Capital Requirements
a) a fraction of the bank’s RWA levels, which are in turn calculated via prescribed processes - Pillar 2 – Supervisory Review
a) Regulator’s opinion on the safety of the bank, expressed as an additional capital amount.
Includes regulators’ view of how well risk management processes are functioning - Pillar 3 – Disclosure and Market Discipline
Requirement to disclose information regularly to market in a standard format
Three Pillars approach
- Was for capital, now also for…
- How to incentivise behaviour
1 Originally just for capital, but 3 pillars approach now also adopted for liquidity regulation
2 To incentivise behaviour, Pillar 2 capital overlays have to be linked to management actions
Pillar 1 (prescribed by formula) - List examples of:
Types of Capital
- Tier 1 (Going Concern) Capital to absorb losses without placing the bank into insolvency or liquidation
- Tier 2 (Gone Concern)
Capital that can absorb losses during insolvency but before debt investors incur any loss
- Tier 1 (Going Concern) >= 6% RWA
- Common Equity Tier 1 (CET1): Highest quality capital, incl common shares and ret’d earnings. >=4.5% RWA (Pillar 1)
- Alternative Tier 1 (AT1)
Ranks above CET1, but subordinate to other
liabilities ‐ incl “Contingent Convertibles” (CoCos) that automatically write down or convert to equity in times of stress - Tier 2 (Gone Concern)
- Tier 2 (T2)
subordinated term debt of 5+ years original maturity, general loan loss provisions (capped)
Pillar 1 (prescribed by formula)
- Contingent Convertibles (Cocos) / Alt Tier 1
QN: List the 2 key parameters
• Two key parameters:
1. Trigger Event: instigates conversion process – may be objective and/or discretionary
2. Loss Absorption Mechanism: conversion to equity (typical) or write‐down of principal
– Many variations, and up to issuer to structure an instrument attractive to the market
Pillar 1 (prescribed by formula)
Capital Buffers - list types
– Cap Conservation Buffer (CET1 = +2.5% RWA)
bank keeps operating but with restrictions on staff bonuses + dividends
– Sector‐Specific Buffers (UK)
Cap charge on lending to sectors of the economy that would create risk to the financial system
– Countercyclical Buffer (CET1 up to +2.5% RWA)
Additional cap to be built up countercyclicaly
– Systemically Important Buffer (CET1 up to +4.5% RWA in USA, +3.5% RWA in Europe)
Additional cap to ensure systemically important banks are safer
• Last three examples of “macro‐prudential” regulation – targeting financial system as a whole
Pillar 1 (prescribed by formula)
Buffers, from 1 Jan 2019
- list stack
(stack) * Countercyclical (up to 2.5%) * Systemically important (up to 4.5% * Capital Conservation (2.5%) * Max T2 (2%) Max AT1 (1.5%) * Min CET1 (4.5%)
Pillar 1 (prescribed by formula)
Buffers, from 1 Jan 2019
- Capital range on RWA including buffers
- RoE =
- Impact on RoE
- Capital moves from current 8% RWA to a range of 10.5% ↔ 16.5% RWA
- Gross return‐on‐equity (RoE) from lending = margin x leverage
- Assuming margins and risk weights stay constant, then some gross lending RoEs could halve
Pillar 1 (prescribed by formula)
Basel 3 has introduced new classifications: (sometimes overlapping)
– SIFI (“Too‐Big‐To‐Fail”)
Systemically Important Financial Institution – colloquial umbrella term for banks, insurers, etc.
– G‐SIBs and D‐SIBs (BCBS)
Global / Domestic Systemically Important Banks ‐ the global G‐SIB list currently contains 30 banks
– G‐SIIs (EBA)
Global Systemically Important Institutions – assessed at a consolidated group level
– O‐SIIs (EBA)
Other Systemically Important Institutions ‐ assessed at either a consolidated or subsidiary level
Pillar 1 (prescribed by formula)
- Current List of G-SIB and D-SIB
- APRAs current buffer settings
• No Australian banks in G‐SIB list • Four D‐SIBs in Australia – ANZ – NAB – CBA – WestPac • APRA’s current buffer settings: – D‐SIB = 1% RWA – Countercyclical = 0% RWA
Pillar 1 (prescribed by formula) Total Loss Absorbing Capital (TLAC)
- define
- applies to:
- includes what types
- Australia?
• more expansive definition of loss‐absorbing assets, with constraints applying only to G‐SIBs
• TLAC can be cap or qualifying unsecured long‐term sub debt (not just cap)
* long term (> 1 yr) sub debt + CET1 + AT1 + T2
• Cap absorbs the loss, and defaulting on lowest tier of debt then sufficient to recapitalise
• Extensive rules to address parent‐subsidiary structures, cross holdings, etc.
• From 1 Jan 2019: TLAC ≥ 16% RWA and ≥ 6% total assets (twice the Pillar 1 capital measures)
• APRA asked to look explore a similar regime for Australia, but no firm deadline imposed
Pillar 2 (assigned by regulator)
MREL (Europe)
- define
• MREL = “Minimum Requirement for Own Funds and Eligible Liabilities”, part of the “Bank Recovery and Resolution Directive” (BRRD)
• Similar to TLAC (recap by default on sub debt), however MREL is:
– Euro std, all banks and investment firms, not just G‐SIBs
– Expressed in terms of total liabilities, not risk‐weighted
• European G‐SIBs (13 of the 30) will have to comply with both
• Also represents significant work for regulators:
– BoE to set MREL for all banks, building societies, and 730k investment firms
Pillar 2
MREL - instruments
- Ranks above T2 (and hence above AT1 and CET1), but below senior unsecured bonds
- Terms allow principal to be written down in resolution, or converted to a more junior liability
- Not a CoCo (AT1) as trigger for write down is that the bank no longer a going concern
WACC
- define
- tax term
- only an approximation because..
• average cost of funding across all liability types
• Tax term recognises that debt servicing, including AT1 and T2, is a pre‐tax cost – unlike equity
• Only an approximation as K will have a dependency on the composition of the balance sheet
– Market will demand a higher return to lend to a bank that is already highly leveraged
• Useful as a marginal measure – lending at less than current WACC will reduce profitability
Economy of Scale vs Too big to fail
• Research indicates growth can deliver at least as much benefit to bankers as to investors [1]
• Direction of regulation post‐crisis is to work against this, to discourage “too‐big‐to‐fail”
• G‐SIB/G‐SIFI status is one aspect of this – extra capital – but also extra costs, reporting etc.
• One response is to split into smaller (connected) companies that remain part of a group [2]
- regulators nervous about outsourcing
Key points - Prudential regulation
- requirement for banks to…
- reduces overall profitability because..
- impacts = uniform?
- Banks to hold more cap to absorb losses and protect from insolvency
- Cap = higher quality to function when needed
- Cap to absorb losses to be backed up by “defaultable debt” to recapit post insolvency
- Reduces overall banking sector profitability, and assigned risk weights will influence lending
- Impacts are not uniform, but instead are targeted at largest institutions (“too‐big‐to‐fail”)
Pillar 1: Liquidity Regulation
Why is Liquidity Important - difference between solvency and liquidity
• Solvent = able to pay all debts eventually → assets are of sufficient value to cover debts
• Liquid = able to pay near‐term debts as they become due → assets can be turned into cash
Solvent + Liquid = Going Concern
Pillar 1: Liquidity Regulation
Define Liquid but insolvent
LT problem, but may have time to solve (e.g. asset values recover)
• Accounting rules and corp leg’n should force insolvency
• In practice for banks, often better to try to recuperate (e.g. WestPac 1992)
Pillar 1: Liquidity Regulation
Define Solvent but not liquid
- Immediate problem, will need to sell long‐term assets (quickly) to pay debts
- Easiest to sell the best assets, depressing the av quality of assets held
- If sale is at a discount, may mean remaining assets re‐valued downward
- In extreme cases for banks, this can trigger market panic (e.g. Lehman 2008)
Pillar 1: Liquidity Regulation
Define not solvent / not liquid
• No longer viable (“gone concern”)
Pillar 1: (set by rules rather than regulatory direction)
Liquidity Coverage Ratio (LCR)
- Ratio of avail cash and govt securities to f/c net outflows over next 30 days
- Qualifying assets = High Quality Liquid Assets (HQLA)
- LCR ≥ 100% and defined that flows occur in stressed conditions, so deposits are drawn down
Pillar 1: (set by rules rather than regulatory direction)
Liquidity Regulation
Net Stable Funding Ratio (NSFR)
- Ratio of amt of “stable” (longer term) funding to that required by bank’s less liquid assets
- Intended to limit the amount of maturity transformation on banks’ balance sheets
- NSFR ≥ 100% but valuations calibrated to un‐stressed conditions
Pillar 1: (set by rules rather than regulatory direction)
LCR Calc
- Net Cash Outflows
- Assume funding runs‐off in stressed conditions
- Funding with > 30 days to first draw down opportunity are not considered
- Retail demand deposits assigned the lowest run‐off rates, but further divided into “stable” and “less stable”
- Higher run‐off rate for funding from commercial customers
- ST funding from other banks and fin instos assumed 100% drawn down
- Inflows (e.g. from rev‐gen assets) reduced to ≤ 75% of non‐stressed values
- Inflows from HQLA (i.e. that appear in the numerator) must be excluded
HQLA:
2 levels
2 sub levels
Level 1: >= 60%
- Cash, CB reserves, and certain sovereign‐backed debt instruments, valuations 100% weighted
Level 2: =
Committed Liquidity Facility (RBA)
• Aus: not enough HQLAs - Aus govt debt is low
• Aus has a net CAD but it is funded via the commercial banking system
• RBA and APRA developed the CLF
• Allows banks to pre‐position assets for CB repo, at known rates:
‒ 15bp ongoing fee on total facility amount, and cash rate +25bp on any drawn amount
• APRA recognised the CLF in its implementation of the LCR (APS210)
• South Africa has also implemented CLFs, for the same reason
Net Stable Funding Ratio
NSFR = Value of Avail Stable Funding / Value of Required Stable Funding
ie ASF / RSF
NSFR >=100%
Net Stable Funding Ratio
List Required Stable Funding (RSF) Factors
- weighting ranges from 0% for coins / banknotes / CB reserves to 100% for encumbered assets >1 yr and other assets
Net Stable Funding Ratio
Available Stable Funding (ASF) Factors
ASF weights components, assessing the term 1 year) and stability of instrument (eg stable and less stable deposits)
ALso - funding by sovereigns or non financials, etc.
• NSFR and LCR split non‐term deposits into “stable” and “less stable”, where former includes
retail customers with broad bank relationships or with transactional accounts (e.g. salaries)
• This means there is an economic benefit to being your customers’ primary transaction bank
* Note funding cliffs, as various instruments roll down the curve and are weighted differently (eg at the 6 month and 1 year point)
Strategies to Increase NSFR
List 2
- Increase Available Stable Funding (ASF)
2. Decrease Required Stable Funding (RSF)
Strategies to Increase NSFR
- Increase Available Stable Funding - eg…(3)
- Increase Share of Deposits (and increase share of stable deposits vs less stable deposits)
- Extend maturity of wholesale debt > 1 year
- Increase share of Tier 1 capital
Strategies to Increase NSFR
- Decrease Required Stable Funding - eg…(3)
- Shrink the Balance Sheet (shrink loan portfolio; sell assets that are 100% funded)
- Change composition of investments (sell lower rated investments for cash, replace lower rated investments with higher rated)
- Change composition of loans (substitute retail loans with corporate loans and mortgages, reduce maturity of corporate loans to
Liquidity Regulation
- available liquidity changes after every transaction
- monitoring is continuous
Qn
List steps in the definition of LCR and NSFR
Is knowing LCR and NSFR now sufficient?
• There are a series of “steps” in the definitions of both LCR and NSFR:
‒ The 30 day LCR window
‒ The 6 month and 1 year residual maturity criteria embedded in the ASF of the NSFR
• Introduces “cliff risk” on the passage of time – step changes as cash flows enter/exit windows
Not sufficient to know LCR + NSFR now, also need to forecast their values in the future
Liquidity needs to be built into internal pricing models (FTP), and design of products
Pillar 1: Mostly built on categorisation - assets
RWA Assets
HQLA Assets
RWA ASSETS are a function of... • Obligor Type • Obligor Credit Rating • Collateral Type • Collateral Value (Real Estate) • Original Maturity (Interbank Loans)
HQLA ASSETS are a function of... • Asset Type • Encumbered Status • Obligor Type • Obligor Credit Rating
Pillar 1: Mostly built on categorisation - assets
- Expected Inflows - 30 days
- RSF
Expected Inflows: 30 days
• Asset Structure
• Obligor Credit Rating
• Time of Estimate
RSF • Obligor Type • Asset Type (inc. HQLA + RWA categories) • Encumbered Status and Timescale • Residual Maturity
Pillar 1: Mostly built on categorisation - Liabilities
- Capital Seniority and Class
- Stressed Outflows (30 Days)
- Capital Seniority and Class is a function of Instrument Type
- Stressed Outflows (30 Days) is a function of
• Liability Structure
• Cost Structure
• Stressed Assumptions
• Time of Estimate
Pillar 1: Mostly built on categorisation
Liabilities (ASF)
Assets (RSF)
ASF is a function of: • Investor Type • Liability Type (Capital or Debt) • Stability Classification • Residual Maturity
RSF is a function of • Obligor Type • Asset Type (HQLA + RWA categories) • Encumbered status & timescale • Residual Maturity
Pillar 2
1. UK Pillar 2 - 2 subcomponents
Subcomponents
– Pillar 2A – Risks not fully captured in Pillar 1
(pension risk, concentration risk, interest rate risk in the banking book (IRRBB), etc).
Banks estimate, with guidance from regulator
– Pillar 2B – Additional risks a bank may become exposed to over its planning horizon. Stress test.
• Pillar 2 is part of the “floor” capital requirement upon which the capital buffers are applied
• Pillar 2 outputs are generally confidential and banks not permitted to disclose (their “score”)
• Regulators cooperate on common guidelines for Pillar 2 for consistency
Omission from Pillar 1: Concentration Risk:
- Banks monitor concentration by…
- Regulators use…
- Be cautious of..
- Banks monitor concentration by…measuring concentration in industry, geography, exposure
- Regulators use…Herfindahl-Hirschman Index (HHI) = sum of the weights of each category
- caution: classifications: eg petroleum / petroleum manufactured products / retail petroleum products could be classified as Mining / Manufacturing / Retail, yet risks would be correlated
Issues with Interbank Trading and Derivatives
- Most derivatives are:
- Issues with ___________ and ___________
- Difficulty obtaining ______________during the crisis
- Regulatory Reponse has been 2-fold: a)______ b)____________
- Most derivatives are: OTC
- Issues with transparency and credit risk (not factored in)
- Difficulty obtaining fully netted derivatives and swap positions during the crisis
- Regulatory Response has been 2-fold: a) INFRASTRUCTURE: centralise trading with a capital charge on derivs b) discourage complex, non standardised products
Central Clearing Counterparties (CCPs)
- Bilateral trades replaced with:
- How is a default covered
- Requires…
1…replaced withpairs of back‐to‐back trades with a central counterparty (CCP)
2 Participating banks finance a reserve fund at the CCP to cover a bank defaulting on its trades
3 Requires traded products to be standardised
